Against the Grain

PFF

Post navigation

I don’t think I could ever work for a macro-strategy investment company. When I hear about investment ideas centered around relative currency strength, anticipated interest rate movement, commodity prices, and yes, world-wide oil supply/ demand, my head starts to spin and I have trouble seeing the forest from the trees. I’m much more comfortable opining on whether I think people would prefer to eat a Big Mac or Whopper (and who has a better balance sheet) than what’s going to happen to worldwide beef prices because of the political situation in Brazil. That doesn’t mean that I don’t at least try to understand macro issues and their implications; rather, I try to know my limitations and keep the faith that my investment strategy will eventually weather various macro storms I don’t fully understand if I can find good value in great long-term businesses.

With oil prices down almost 50% in the last six months alone, every investment expert is weighing in with their view on how this will affect the market. It’s a complicated issue- obviously lower gas prices for consumers is great in that people can spend their money on other things and great for countries that rely on importing gas, but it’s not so great if energy-related loans start defaulting and impacting banks or the U.S. loses a big chunk of the previous job gains over the past 5 years that were energy related.

My conclusion on this whole issue is that I simply don’t know what’s going to happen with oil prices and how it will affect the overall market, so I’d like to explore opportunities within the market that are less impacted by oil prices (or ideally not at all impacted).

Below are some of my thoughts on stocks/ themes that meet two criteria: (i) I think they are good stand-alone investments ideas for 2015 and (ii) I don’t think that oil price movement (good or bad) will have a huge impact on their success or failure.

Battered down brand names/ re-positioning stories:

Weight Watchers (WTW): After a fantastic 50% run-up in the second half of 2014 due to new leadership, improved technology, earnings beats, and revised upward earnings estimates, the stock has mysteriously lost 30% in value over the past 3 weeks alone with no material news other than the fact that some people didn’t “like their new magazine layout”. I’m still a believer in what the new management team is doing and am looking forward to another nice run.

Hertz (HTZ): Despite being transportation related, I don’t think oil prices will swing the dial much for Hertz; it all comes down to whether the new leadership can execute a successful turnaround and restore investor confidence in their operations, strategy, and reporting. If they can, this stock has tremendous upside. If they can’t, you are at least left with an iconic brand name and infrastructure that is near impossible to replicate.

Lower-end consumer product and food companies:

YUM Brands (YUM): People might eat a little more junk food with lower oil prices, but a larger driver of growth for companies like YUM (parent company of KFC, Taco Bell, and Pizza Hut) is their ability to grow into new markets and take share from competitors. moMANon wrote a great piece on YUM and why he feels that the Pizza Hut re-branding has the potential to take some meaningful market share from its competitors and move the earnings dial for YUM.

Health/ organic oriented food companies:

Whitewave Foods (WWAV): The other day at the grocery store I was shocked to have paid more for a gallon of organic milk for my kids than I typically pay for a gallon of dairy alternatives like soy or almond milk. Oil prices won’t dictate whether people drink milk or diary alternatives, and Whitewave has been on fire with 10 straight quarters of beating earnings expectations, year-over-year revenue growth exceeding 40% and encouraging new partnerships in china to expand their reach. ATG is going long again on lactose intolerance.

High Tech:

My personal favorite play here is probably Corning (GLW), the leading manufacturer of durable glass for tv’s, phones, and tablets. I don’t have a great “ATG” theory of why they will outperform other than I just love the company, their market dominance, and ability to continue innovating over the past 100+ years. Google (GOOGL) also feels cheap to me right now, but if oil prices cause an overall market shock downwards for some reason, I could see the mega-cap, high trading volume companies getting crushed simply from investor fund withdrawals.

Non-equity income and dividend plays (non-energy related of course!):

There’s nothing wrong with parking some money in non-equity dividend plays if you are nervous about energy prices rocking the market. Within the ATG portfolio we have increased our allocation to iShares U.S. Preferred Stock ETF (PFF), a large basket of predominantly bank-related preferred shares that are currently yielding 6.33%. If low oil prices were to trigger bank defaults, PFF would certainly be impacted, but not nearly as much as the underlying equities would be impacted.

With over 3,000 publicly traded companies in the U.S. alone and who knows how many mutual funds and ETF’s, investors have plenty of opportunities to pick their spots and limit exposure to certain factors of their choosing. I’m not staying away from the market, but I am staring away from big oil price bets in my personal portfolio for now.

I suppose it’s my turn to provide a quick take on the current make-up of ATG’s portfolio and thoughts on specific equities. While I have a few regrets (such as not buying Royal Caribbean at moMANon’s behest in hopes of buying a little cheaper and not picking up a larger entry position of Whitewave Foods), overall I’m happy with the current makeup of our portfolio and the various trades over its first 6 months.

OZM- At 16% of invested capital, Och-Ziff is our largest holding in the portfolio, more as a result of picking up more shares on weakness than overt confidence. I am extremely interested to see how their third quarter earnings pan out on November 4- the beauty of this stock is that they distribute most of their earnings as a dividend and it’s priced so cheap that their funds only need to gain a few ticks above 0% to generate adequate profits. The downside is that that they primarily play in international alternative investments, an area where getting a few ticks above 0% is no easy task in today’s environment. I’m a HOLD on this one.

ESV- Admittedly, I keep getting this stock wrong. It has been the worst performer of the ATG portfolio, with an unrealized loss of 13.5% to date. Plummeting oil prices coupled with concerns about over supply in the offshore rig industry have outweighed positive earnings results, a stable balance sheet, attractive dividend yields, and continued backlog of revenue for the company. Perhaps this is my version of the Ackman-Herbalife complex, but I’m convinced that ESV is destined to turn around- today’s earnings announcement of a solid beat and 3.2% gain is a good start. It’s hard to find a best-in-class company that generates ample profit, cash flow, and trades at a price below net book value of assets, even after excluding intangibles. I’m a believer in Ensco, but keeping a HOLD rating relative to the ATG portfolio given our large position.

GOOGL- I like monopolies, low leverage, strong revenue growth, and cutting edge technology investments at a price equal to the average S&P P/E ratio. STRONG BUY. We’ll be adding more soon.

VNM- Vietnam index, this is a tough one. I like this play a lot in the long run, but I’m annoyed by the nature of emerging market ETF’s like this where local players can anticipate the ETF buys for particular stocks in advance and move the market (increasing the ETF basis); I’m also cautious about emerging markets in general over the next couple of years. I think we’ll see a lot of volatility here and will need to buy on dips/ maybe sell on big upswings over the next year or so, hence the HOLD/ WATCHING WITH CAUTION rating.

HTZ- Hertz is a fascinating story, not too dissimilar to WTW: incredible overall market demand drivers for the industry but company-specific misteps and under-performance. If you missed my prior post on Hertz, check it out for more detail on why I’m intrigued, including how Carl Icahn bailed my ass out of the initial trade. We’re back in now that the stock has plummeted from $31/ share to around $20 share and has removed their CEO. While there may be some short-term turbulence as they eventually re-state their earnings and name a new permanent CEO, I’m extremely bullish on this stock over the next 12 months. STRONG BUY.

DE, PHM, DNOW, CLNY- I’m going to pull a Bill Simmons and group all these stocks together because (i) I’m lazy and (ii) they all share the similar characteristic of being what I consider relatively safer, industry leading stocks at attractive P/E ratios that I don’t lose any sleep over. We’ll buy on dips but they also aren’t likely to sky-rocket any time soon. The overall theme is increased importance on agricultural equipment/ farming efficiency, eventual millennial movement towards starting families and moving into new homes, continued energy/ oil industry growth in the US via a Warren Buffet supported spin-off, and attractive risk-adjusted real estate returns via a super smart shop that plays in both debt and equity (including rental residential).

WTW- In the last 3 months, Weight Watchers notched a staggering 53% gain from $19.25/ share to $29.42/ share before dropping 13% today despite a healthy earnings and revenue beat (but a 12% reported loss in overall membership). We’ve done well on this stock, and any reader of this blog knows that I’ve been cheer-leading it for over a year (admittedly more in bad times than good).

After reading the earnings transcript, the clear strategy set by new CEO Jim Chambers, and witnessing the measureable improvement of Weight Watcher’s technology presence (app integration with fitbit, iphone6, jawbone, etc.) I remain a steadfast believer in the stock.

The only caveat is that I actually did a little “gonzo investment research” and joined a new weight watchers group through my company to see what the program was like from the inside. I lasted one meeting- out of the total 18 people in attendance, there were literally 17 women staring down the 1 man with total disdain. I knew that Weight Watchers was overwhelmingly women, but I never fully appreciated the company’s challenge in attracting men to their onsite meetings until being there in person and feeling the awkwardness. I was very impressed by the initial Simple Start program and could immediately see the benefit of their group weight loss approach, but I think the programs need to be separated by gender if they ever hope to gain critical mass from the dudes. They also need a dude sponsor that men can actually relate to: Jonah Hill or Seth Rogan need to get fat again!!

The ATG Investment team has finally gotten off its ass and opened its joint investment fund. On a monthly basis we will update the positions and share true performance of the fund in the “Current Portfolio” tab of this blog. On April 17 we established initial positions in 7 different securities and allocated a total of 25% of the available capital to these stocks. Over the next several months we intend to slowly build up the investment fund to approx. 80% invested in the market with 20% in cash as a buffer. The investment allocations of each security are reflective of our perception of current price- for example, WWAV has a smaller allocation than ESV currently due to the recent run up in its price before we established an initial position. If pricing dynamics change 30-60 days from now, we will adjust the allocation to try and take advantage of pricing and build a more favorable basis in any given security. We plan to limit the total number of different investments at any given time to around 10. Our logic is that its enough to provide meaningful diversification but not too many to lose focus or dilute the ATG team’s best overall ideas.

Without further adieu, below is the initial ATG portfolio:

OZM (Och-Ziff), ESV (Ensco), CLNY (Colony Financial), WWAV (White Wave Foods), and PFF (iShares Preferred Shares ETF) have all been discussed in prior ATG posts. GOOGL (Google Class A) was a bit of an impulse, last minute add to the portfolio in light of their recent modest price drop. Any portfolio should have some high quality tech exposure, and GOOGL is probably the most reasonably priced of the high growth names at 17x 2015 forward earnings.

VNM (Market Vectors Vietnam) is an ETF that tracks the Vietnamese stock market. Both Maverick and moMANon have had the opportunity to visit the country before and are in agreement that this is our favorite emerging markets bet right now (and favorite southeast Asian cuisine option). I’m sure an ATG post is forthcoming laying out our argument for the opportunity.

Overall we’re trying to build a portfolio that balances attractive yield (PFF, ESV, OZM, CLNY) with higher growth/ beta securities (VNM, WWAV, GOOGL) in hopes of beating the S&P 500 and earning positive returns even if the market ends down for the year. We are also trying to stay true to the original ATG principal that any security we pick is one that we’d be comfortable holding for several years to ride out any wild, unpredictable market moves.

As always, we welcome any feedback or thoughts as we build up the portfolio and share the performance publicly. To avoid any misunderstanding from potential readers, I want to make it clear that the ATG Fund represents only a portion of the ATG team’s respective personal investment strategies. Any responsible personal investment strategy should have diversification among various investment classes (stocks bonds, real estate, etc) and have a meaningful percentage of diversified index/ mutual fund holdings in addition to any individual securities. For any readers who’d like to talk more about an overall investment strategy, write us a message and we’ll be happy to share our thoughts.

Today there are several different options available for investors searching for high yielding/ dividend securities in a low treasury rate environment. I can only imagine how often a new client walks into a financial advisor’s office and says “if you can get me a nice safe 5% return today I’d be very happy.”

Right now my personal portfolio is lacking in yield right now. I have a healthcare REIT (HCP, yielding 5.9%), two high yielding oil rig stocks (Transocean and Ensco, both around 5.5%) and a mortgage REIT (Colony Financial, yielding 6.4%), but no bond or preferred stock exposure (in my actively managed account). I’ve been hesitant to buy bonds or preferred stock over common fears that interest rates will suddenly jump once the economy is back on track and a subsequent drop in principal value will wipe out the benefit of current yield. Hence, I’ve been grabbing yield from other securities that I perceive as less directly correlated to interest rate movements. Today I finally decided to see what the real correlation (extent to which they move in tandem) has been between the 10 year treasury rates and various yield vehicles over the past 7 years:

________________________________________________________________

After running the correlations based on monthly total return data (i.e. including dividends and interest as part of the return) over a few different periods I quickly realized how complex the answer to my initial question proves to be. With the exception of the Total Bond Market ETF (BND), which maintained a strong negative correlation with the 10-year treasury rate over every period tested except the financial crisis of 2009, the other yield vehicles exhibited a wide range of correlations (both positive and negative), making any definitive conclusion difficult. Below are a couple of personal observations based on the data:

• Vanguard REIT Index (VNQ): As I expected there has been relatively volatile correlation between REITs and treasury rates over the past 7 years. If you believe that the economy will continue to steadily improve then I think REITs can make for an attractive yield option in the face of rising rates, particularly given real estate’s ability to act as an inflation hedge. (Keep in mind REITs are more correlated to the market than private real estate funds, however.)

• Preferred Stock ETF (PFF): Correlation between the preferred stock ETF and rates have been extremely volatile over the past 7 years, with the correlation being highly negative in 2013. While the data isn’t conclusive my gut tells me that this vehicle won’t get rocked by rising rates any time soon and has a place in a dividend portfolio.

• High Yield Bond ETF (HYG): When comparing the annual correlations for HYG, which ranged from (0.52) to 0.76, I can’t figure out why the cumulative 7-yr correlation is (0.63). Logically this doesn’t make sense to me but I checked the formulas multiple times and couldn’t find an error. On a cumulative basis it does make sense that the correlation for high yield debt would fall in between that of preferred stock and the bond market overall, however.

• Colony Financial (CLNY): I added this specific mortgage REIT only because it’s one of my favorite investments right now. While classified as a mortgage REIT, Colony has a fairly diversified real estate strategy that includes a large pool of single family homes held as rental product, loan origination, investment in distressed debt world-wide, equity interests in hotels, etc. I bought it as a yield pillar (to borrow a phrase from moMANon) with the idea that their strategic flexibility, low cost of capital and super smart investment team could overcome rising rate risk. So far that appears to be holding up as evidenced by a cumulative correlation against treasury rates of only (.14) since inception of the company.

While this analysis would have been infinitely more enlightening if I could have compared each vehicle over a longer period of time (such as when rates sky-rocketed in the late 1970’s), I hope you manage to find some value in the data as you decide what yield vehicles make sense for your portfolio. As you consider alternative yield options Continue reading →